Tuesday, March 4, 2008

Risks From The Current Recession

The Guru of Omaha, Warren Buffet, stated yesterday that the economy is in a Recession[i]. Even Chairman Bernanke stated this in his February 27 Semiannual Monetary Policy Report to the Congress[ii] [bold and italics added for emphasis]:

“The risks to this outlook remain to the downside. The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further.

The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend and the unemployment rate edging lower; the improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term.”

There you have it. We are in a recession and we will not see any major improvements until 2010. As if there were any doubts, FDIC adds more gloom to the news, as noted by the Wall Street Journal report, FDIC to Add Staff as Bank Failures Loom[iii]:

“The Federal Deposit Insurance Corp. is taking steps to brace for an increase in failed financial institutions as the nation's housing and credit markets continue to worsen.

The FDIC is looking to bring back 25 retirees from its division of resolutions and receiverships. Many of these agency veterans likely worked for the FDIC during the late 1980s and early 1990s, when more than 1,000 financial institutions failed amid the savings-and-loan crisis.

"Regulators are bracing for well over 100 bank failures in the next 12 to 24 months, with concentrations in Rust Belt states like Michigan and Ohio, and the states that are suffering severe housing-market problems like California, Florida, and Georgia," said Jaret Seiberg, Washington policy analyst for financial-services firm Stanford Group.”

OK, we are now in a recession that will last a while and may see over 100 bank failures. But wait; there’s more:
1. Consumers are cutting back on conspicuous consumptions[iv].
2. Restaurants are also facing hard times with same-store sales declining and cost of material increasing[v].
3. With oil closing over $102 per barrel, the news that sales at the automakers are declining is no surprise[vi].
4. Companies are battening down for a long haul; the job market is drying up[vii].
5. Those who are still working are working longer hours to fill the gaps, resulting in sleep deprivation[viii].
6. U.S. manufacturing activity fell to a five year low[ix].
7. Independent truckers cannot make ends meet as fuel prices soar while demand for their services dry up[x].
8. Increasing prison population – 2.3 million as at end of 2007 – is increasing[xi]

Given These Data Points, Here Are The Risk Issues To Think About:
Adverse Impact On GDP:
As consumers begin to cut back on consumption, many businesses will experience lowered revenue stream, leading to cutbacks in service, reduced service hours, wage freeze, and, for some, eventual closures. Additionally, increased fuel price combined with higher raw material prices[xii] are leading to lowered profit for manufactures.

§ High risk of $422.5 billion reduction in GDP, based on 3% reduction of 2007 GDP of $14,084.1 billion[xiii]

§ Increase Stress On State and Local Governments: The combination of lower wages and reduced business revenues will result in lowered tax receipts for state and local governments. In rust belt states, increased unemployment and increasing foreclosure rates combined with house abandonment will lead to increase in vandalism, crime, and illicit businesses. This will increase the state and local governments’ outlay for public safety and correction.

§ High risk of $4.9 billion in additional correction cost, estimated at 10% of $49 billion expended in 2007[xiv]

§ High risk of $3.6 billion increase in unemployment insurance (UI), estimated at 5% of UI claim of 2.8 million as at February 16, 2008[xv] calculated at $1,000/person (my guessitimate) for 26 weeks (typical UI limit).

§ High risk of $38 billion in reduced tax receipts, estimated at 3% reduction on 9% of 2007 GDP, noted to be state and local governments allocation[xvi]

§ High risk of $21 billion in reduced sale tax receipts, estimated at 5% tax rate on 3% reduction of 2007 GDP (the estimated reduction in consumer spending, above)

§ High Risk of $23 billion in losses resulting from state and local governments modifying their bond obligations or even defaulting – estimated at 20% default rate with 5% loss from default on $2.3 trillion in outstanding muni bonds[xvii]

Lowered Federal Revenue:

§ With slowing economy and more people out of work, tax revenue is expected to decrease. Based on the above estimated decrease on GDP figures, there is a High risk of reduced tax revenue.

§ High risk of $63.4 billion in reduced tax receipts, estimated at 15% tax rate (blended estimate of personal and corporate tax rates) on $422.5 billion reduction in GDP.

The signs are out there and I have simply laid out some of the major risk issues and their potentials for losses. While the possibility of the above estimated losses is increasing, proactive efforts, jointly by private and public sectors, to mitigate these risk factors may help to reduce the severity of losses.

In the spirit of Damon Runyon’s quote – “The race is not always to the swift, nor the battle to the strong, but that's the way to bet.” – high risk of losses doesn’t always mean there will be one, but that’s the way to plan and act.

Ed Kim
DISCLOSURE: The author is Long Berkshire.
[i] http://news.yahoo.com/s/nm/20080303/bs_nm/buffett_dc_8
[ii] http://www.federalreserve.gov/newsevents/testimony/bernanke20080227a.htm
[iii] Wall Street journal, FDIC to Add Staff as Bank Failures Loom, February 26, 2008, by Damian Paletta
[iv] http://www.usatoday.com/money/economy/2008-02-26-consumers-cut-small-luxuries_N.htm
[v] http://www.usatoday.com/money/industries/food/2008-03-02-restaurants-economy_N.htm
[vi] http://www.nytimes.com/2008/03/03/business/03cnd-auto.html?ref=business
[vii] http://www.nytimes.com/2008/03/02/business/02jobs.html?em&ex=1204693200&en=8a73dc22a0bf3e56&ei=5087%0A
[viii] http://www.usatoday.com/money/workplace/2008-03-02-sleep-deprived-workers_N.htm
[ix] http://news.yahoo.com/s/nm/20080303/bs_nm/usa_economy_dc;_ylt=Au2o4EwnA2cqrDg1wgqGHPq573QA
[x] http://news.yahoo.com/s/ap/20080301/ap_on_bi_ge/truckers__trouble
[xi] http://jurist.law.pitt.edu/paperchase/2008/02/one-in-100-us-adults-in-prison-pew.php and http://www.pewcenteronthestates.org/news_room_detail.aspx?id=35912
[xii] http://www.ism.ws/ISMReport/MfgROB.cfm
[xiii] http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
[xiv] http://www.pewcenteronthestates.org/news_room_detail.aspx?id=35912
[xv] http://www.dol.gov/opa/media/press/eta/ui/current.htm
[xvi] http://online.wsj.com/article/SB120036069725690073.html?mod=djemITP
[xvii] http://www.pimco.com/LeftNav/Bond+Basics/2007/Muni+Bond+Basics.htm

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